Quantitative Easing Is Not Always Negative For The Dollar

The U.S. dollar fell sharply today following the Federal Reserve's announcement last week of an open ended Quantitative Easing program. While the Fed needs to create more money to engage in QE, Quantitative Easing is not always bad for the dollar. There have only been two cases of QE -- making our statistical sample completely unreliable -- however, it is nonetheless interesting to look at how the dollar performed against the euro and Japanese yen in the days, weeks and months that followed QE1 and QE2. When the central bank took the monumental step of announcing the first round of Quantitative Easing on November 25, 2008, the U.S. dollar fell against the euro (or EUR/USD rallied) and the Japanese yen. The next day, however, the dollar recovered and rallied for four straight trading days before collapsing hard against the euro. On the other hand, USD/JPY took a longer time to recover. The currency pair lost 1000 pips in the three weeks that followed (falling from 97.40 to 87.20) before stabilizing and recovering all of those losses. By March or April of that year, USD/JPY was trading higher, but as we know now, the gains did not last.

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When the Fed announced its second round of Quantitative Easing on November 3, 2010, the dollar also fell against the euro the day of the announcement, but recovered the day after and began an 8% rally that lasted for the next month. In other words, QE2 created a short-term bottom for the U.S. dollar against the euro. The same price action was seen in USD/JPY, which also bottomed after the Fed made its announcement, rising approximately 6% over the next month. The one consistent reaction to QE1 and QE2 was in stocks, which soared after both rounds of Quantitative Easing.

The reason why the EUR/USD reacted more significantly to quantitative easing than USD/JPY is because at the time, the monetary policies of the U.S. and eurozone were more divergent than the monetary policies of the U.S. and Japan. If we look a year forward, in both cases, the dollar was lower than where it was before Quantitative Easing. The main reason why Quantitative Easing isn't always bad for the dollar is because investors are often relieved to receive more support from the central bank. QE2 was far more beneficial for the U.S. dollar than QE1 because it wasn't a surprise. The market had been talking about it for weeks, and investors had plenty of time to position for the announcement -- classic sell the rumor and buy the news. This is not to say that this time around, the dollar won't remain weak. If Europe doesn't give investors a reason to seek safety in the U.S. dollar, the EUR/USD could extend its gains. However, losses in USD/JPY could be limited to 76, as investors grow wary of Bank of Japan intervention.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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